These two equations are equivalent because the sales terms cancel out in the second equation. The first term on the right hand side of the equation is margin, which is defined as follows:

Margin = Net operating income / Sales

Margin is a measure of management’s ability to control operating expenses in relation to sales. The lower the operating expenses per dollar of sales, the higher the margin earned.

The second term on the right hand side of the equation is turnover, which is defined as follows:

Turnover = Sales / Average operating assets

Turnover is a measure of the sales that are generated for each dollar invested in operating assets.

The following alternative form of the ROI formula, which we will use here, combines margin and turnover.

ROI = Margin × Turnover

Both the formulas give same answer. However margin and turnover formulation provides some additional insights. Some managers tend to focus too much on margin and ignore turnover. To some degree the margin can be a valuable indicator of a manager’s responsibility. Standing alone, however, it overlooks one very crucial area of manager’s responsibility–the investment in operating assets. Excessive funds tied up in operating assets, which depresses turnover, can be just as much of a drag on profitability as excessive operating expenses, which depresses margin. One of the advantages of return on investment (ROI) as a performance measure is that it forces the manager to control the investment in operating assets as well as to control expenses and the margin.

When return on investment (ROI) becomes a very crucial to judge the performance of investment centers managers, managers need to improve ROI of their centers. An investment center manager can improve ROI in basically three ways.

To illustrate how an investment center manager can improve ROI by making the use of three methods mentioned above consider the following example:

Example:

The following data represents the results of an investment center of the operations of a company for the most recent month.

Net operating income
Sales
Average operating assets

$10,000
100,000
50,000

The rate of return generated by the company for this investment center is as follows:

ROI = Margin × Turnover

(Net operating income / Sales) × (Sales / Average operating assets)

($10,000 / $100,000) × ($100,000 / $50,000)

10% × 2

= 20%

As we stated above that manager can increase sales, reduce expenses, or reduce the operating assets to improve the ROI figure.

Approach 1: Increase sales:

Assume that the manager is able to increase sales from $100,000 to $110,000. Assume further that either because of good cost control or because some costs in the company are fixed, the net operating income increases even more rapidly, going from $10,000 to $12,000 per period. Assume that operating assets remain constant. The new ROI will be:

ROI = ($12,000 / $110,000) × ($110,000 / $50,000)

10.91% × 2.2

24%

Approach 1: Reduce expenses:

Assume that manager is able to reduce expenses by $1,000 so that net operating income increases from $10,000 to $11,000. Assume that both sales and operating assets remain constant. The new ROI would be:

ROI = ($11,000 / $100,000) × ($100,000 / $50,000)

11% × 2.2

22%

Approach 3: Reduce operating assets:

Assume that the manager of the company is able to reduce operating assets from $50,000 to $40,000, but that sales and operating income remain unchanged. Then the new ROI would be:

ROI = ($10,000 / $100,000) × ($100,000 / $40,000)

11% × 2.2

22%

You may also be interested in other articles from “decentralization, segment reporting and transfer pricing” chapter: